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Wednesday, December 31, 2014

'Tis the season of re-gifting, and so I make bold to pass along this list of 16 of the most popular posts of 2014 at this website, at least one from each month, in reverse chronological order. Of course, I encourage you to spend your holidays surfing the Conversable Economist archives; after all, unless your personal interests are perfectly aligned with pageview popularity (and isn't that a frightening thought?), you are likely to find other posts of interest, too.

Tuesday, December 30, 2014

The economy of a country and its potentinal for future growth is based on the skill levels of all workers, not just on those who attend the best colleges and universities. The U.S. has been underperforming in education for decades, and the international statistics show it. Here are a few of the many figures that caught my eye from Education at a Glance 2014: OECD Indicators.

This figures compares the percentage of those with a tertiary education comparing 25-34 year-olds to the education level of 55-64 year-olds. The black squares show the older group; the blue triangles show the younger group; and the light blue bars show which countries have been expanding education in a way that the younger generation is well ahead of its elders. One wouldn't expect the U.S. to have the highest level of gains, given that other countries had much lower levels of those with a higher education several decades ago--and thus greater potential for gains. Still, it's a little shocking to see that the U.S. shows almost no intergenerational gain in education levels, and is second from the bottom in such gains. Tou can also see by the position of the blue triangles that the U.S. is just barely above the OECD average for tertiary education in its 25-34 age group.

A quick retort to these kinds of figures is to point out that perhaps higher education in some other countries is of lower quality, and so it doesn't mean as much to have a tertiary degree. Well, maybe that's part of the dynamic here. But those who are starting to lag behind always complain about the unfairness of what is being measured, don't they?

How about at the high school level? Here are upper secondary graduation rates across countries. The U.S. ranks below the OECD average.

U.S. salaries for K-12 teachers are relatively low, compared with what others with a tertiary education in that country receive. Here's an example showing salaries from teachers in "lower secondary schools," or junior high school

The teaching hours contractually expected from U.S. teachers are relatively high.

On the other side, average class sizes are slightly smaller in the U.S. than the OECD average. Here's an example for primary education classes.

What about enrollment rates in preschool? Again, the US is below the average. As I've expressed before on this blog, my reading of the evidence on the proven gains from early childhood education is not especially encouraging (for exmaple, here and here). But even if the effects of U.S.-style preschool on children can be questions, there's no question that it can serve as a subsidy to help low-income families with the costs of their child care, and to make it easier for mothers in low-income families to keep a better connection with the workforce.

One of the things that "everyone knows" is that the successful economies of the 21st century will be built on high-skilled workers. The U.S. used to lead the world in educating its population, but no longer. Just spending marginally more money on the existing system isn't likely to be a successful answer. Some deeper rethinking is needed.

Monday, December 29, 2014

The sunk cost fallacy appears in every introductory economics course. Rational behavior suggests that people should realize that they can't change the past. The amount of money or time or energy that has already been spent on some project is a "sunk costs," and it should be irrelevant to whether you keep going with the project. When making a choice, you should look only to the future costs and benefits of your actions.

Many people find it hard to disregard sunk costs. There are the romantic relationships that have been lukewarm or worse for a long time, with no likely prospect of change, but where one or both people can't break up because they've been together for so long. There are the investors whose stock portfolio or house has lost value, but who doesn't sell because if they just keep holding on, they can pretend that those losses haven't yet happened. There are large projects in business and government where a lot has been spent in the past, and so the project must be continued into the future--even though its prospects appear grim. Indeed, the sunk cost fallacy is sometimes called the "Concorde effect," after the supersonic jet where development and construction went on long after it was clear that the project was not economically viable.

Some evidence suggests that children and animals may be better at avoiding the sunk cost fallacy than adults. At some level, this makes sense. After all, children and animals may be less likely than adult humans to become ego-involved and locked down into what happened in the past, and thus more likely only to look forward. But I'll also admit that, at some level, this theory also sounds a bit ridiculous to me. How does one test whether children and in particular animals take sunk costs into account? The classic discussion of the evidence here here seems to be a 1999 paper by Hal R. Arkes and Peter Ayton called "The Sunk Cost and Concorde Effects: Are Humans Less Rational Than Lower Animals?" It appeared in a 1999 issue of Psychological Bulletin, published by the American Psychological Association (125:5, pp. 591-600). The journal isn't freely available on-line, but many readers will have access through a library.

As one example, here's a discussion from Arkes and Ayton of a study looking at whether female albino mice take sunk costs into account, or focus only on the future.

A prototypical study ... tested the litter defense behavior of female albino mice. On the 8th day of a mother's lactation period, a male intruder was introduced to four different groups of mother mice and their litters. Each litter of the first group had been culled at birth to four pups. Each litter of the second group had been culled at birth to eight pups. In the third group, the litters had been culled at birth to eight pups, but four additional pups had been removed 3 to 4 hr before the intruder was introduced. The fourth group was identical to the third except that the removed pups had been returned to the litter after only a 10-min absence.

The logic of the Maestripieri and Alleva (1991) study is straightforward. If each mother attended to past investment, then those litters that had eight pups during the prior 8 days should be defended most vigorously, as opposed to those litters that had only four pups. After all, having cared for eight pups represents a larger past investment than having cared for only four. On the other hand, if each mother attended to future costs and benefits, then those litters that had eight pups at the time of testing should be defended most vigorously, as opposed to those litters that had only four pups. The results were that the mothers with eight pups at the time of testing defended their litters more vigorously than did the mothers with four pups at the time of testing. The two groups of mothers with four pups did not differ in their level of aggression toward the intruder, even though one group of mothers had invested twice the energy in raising the young because they initially had to care for litters of eight pups. Thus, the magnitude of expected benefits, not the amount of prior maternal investment, determined the mothers' defensive behavior.

Arkes and Ayton also discuss a number of other animal studies: the behavior of a kind of fish called a convict cichlids (Cichlasoma nigrofasciatum); a study about how female digger wasps provide dead katydids for their larva to consume; the nest defense behavior of savannah sparrow; and others. They discuss alternative interpretations of these studies, but argue that the results generally support the claim that animals don't take sunk costs into account.

What about studies of children? They discuss a 1997 study that tested children in the age groups 5-6, 809 and 11-12 with this question:

Imagine you are at a fairground with your parents. Your mother gives you a 50 pence coin, and your father gives you a one pound coin.After walking around for a while you decide to use the 50 pence cointo buy a ticket for the merry-go-round. [But then you discover that you have lost your ticket./But then you discover that you've lost the 50 pence coin so you can't use it to buy a ticket for the merry-go-round.] Would you use the one pound coin to buy a new ticket? Half the children in each of the three age groups received one of the two sentences inside the brackets. ... [For the older children, when] the money was lost, the majority of the respondents decided to buy a ticket. On the other hand, when the ticket was lost, the majority decided not to buy another ticket. This difference was absent in the youngest children. Note that it is not the case that the youngest children were responding randomly. They showed a definite preference for purchasing a new ticket whether the money or the ticket had been lost. Like the animals that appear to be immune to the Concorde fallacy, young children seemed to be less susceptible than older children to this variant of the sunk cost effect.

Arkes and Ayrton cite some other evidence, not directly related to the sunk cost fallacy, that in some cases young children may act more in accordance with strict rationality than older children or adults, because adults are prone to more complicated strategies, while children don't overthink the situation. Here's a discussion of another study with younger and older children:

The participants ranged in age from 3.6 years to 18 years. Each of them faced a panel containing a horizontal row of three knobs, above which was a signal light and below which was a delivery mechanism for marbles. On each of 80 trials, participants were told to press one of the three knobs. Correct presses would be followed by the delivery of a marble. For all participants, pulling one particular knob was followed by reinforcement, but at a 33% rate for some persons and at a 66% rate for others. ... A participant was deemed to be a "maximizer" if the correct knob was pulled on at least 18 of the last 20 trials. ... [T]he youngest children were more likely to be maximizers than were the participants of any other age. Weir (1964) attempted to explain these surprising results:
"It is likely that the 3- and 5-year olds are drawn to the payoff button on the basis of a simple reinforcement notion only. . .. Older subjects . . . employ complex strategies. . . . It is interesting to note that . . . the belief that there is a complex solution actually results in fewer choices of the most frequently reinforced alternative ... The older participants were `too smart for their own good.'"

The exact reasons why people pay attention to sunk costs are not clear. One hypothesis is that people or organizations just don't like admitting error. Another hypothesis is that when disregarding sunk costs feels wasteful in some way, and people don't like to waste. Yet another hypothesis is that in many aspects of life, there is a positive correlation between past efforts and future payoffs, and so giving up on a project with large sunk costs feels like it is also giving up on future payoffs.

As noted earlier, I'm not confident about interpreting some of the evidence about animals and young children as a strong demonstration that they do ignore sunk costs. But I'm always looking for a lively way to explain basic economics concept to students. Explaining some of the evidence that animals and small childen may be better able to disregard sunk costs--appropriately hedged with caveats-- couuld help some students remember the concept of sunk costs more clearly.

Friday, December 26, 2014

A shadow hangs over the possibilities for commercializing outer space: What are the property rights? Say that a company launched a rocket to the asteroid belt and managed to bring back tons of rare minerals to earth. Would the company "own" those minerals? Every explanation of the basic principles of economics includes a riff on the importance of property rights. After all, if people can't hold property, then the incentives to work or save or invest are vitiated. In "Celestial Anarchy: A Threat to Outer Space Commerce?" Alexander W. Salter and Peter T. Leeson explore the issue of property rights in space. Here's how they set up the argument (citations omitted):

Economists have long highlighted the necessity of private property rights for thriving commercial activity. ... Celestial anarchy thus appears to pose a serious obstacle to flourishing outer space commerce. But what if private parties sidestepped the problem posed by sovereigns’ inability to support celestial property rights by enforcing such rights privately—that is., without reliance on any government? ....[I]t is widely believed that a purely private celestial property rights regime is not possible. This article argues that conventional wisdom is wrong. Celestial anarchy is genuine, but the ostensible problem it poses for the development of outer space commerce is not. Private property rights can and do survive without the endorsement or involvement of any sovereign entity. This suggests that private parties can, if given the chance, enforce property rights in outer space. ... Economic theory demonstrates how private individuals can enforce property rights without reliance on government. And economic reality demonstrates how they in fact do so. There’s nothing special about this theory or its manifestations in practice that would limit it to terrestrial property rights.

How might a system of property rights work? Salter and Leeson offer some examples from international trade. First, an example from history:

In the ninth and tenth centuries a professional class of merchants emerged across Europe. These merchants confronted the central obstacle of international anarchy pointed to above: the absence of a supranational sovereign that could protect international traders’ property rights, enabling the growth of international commerce. ... In response to such obstacles to international commerce, medieval merchants resolved international commercial disputes privately on the basis of merchant-developed law in private, merchant-developed courts. This system of self-enforcing property rights is called the
medieval lex mercatoria (law merchant).

They argue that this system of law functioned because of the “discipline of continuous dealings,” which basically means that it's not worth defying the private law in any given case, because by doing so, you would lose the ability to be protected by the private law in all future cases. They write: "Since the gain from defecting is a onetime gain but the gains lost from defecting even once are forever, if parties don’t discount the future excessively, they earn more by always cooperating than by ever defecting. Property rights are self-enforcing."

Trade disputes in modern times are also often handled by private arbitrators. Salter and Leeson explain (again, citations omitted):

Given the difficulties, and for many years the impossibility, of using national sovereigns to enforce international commercial disputes, contemporary international traders rely on private international arbitration associations instead. Indeed, at least 90 percent of modern international commercial contracts contain clauses stipulating the resolution of contractual disputes via private arbitration. The sums of money at stake in these private courts are enormous. For example, in 2001 roughly 1,500 parties from 115 countries used the arbitration services of the International Chamber of Commerce (ICC), the largest of such organizations, in property conflicts that ranged in value from $50 to $1 billion. Over 60 percent of these disputes were for amounts between $1 million and $1 billion.

Over time, international treaties now mean that national governments have agreed to enforce the decisions of these private panels: "In 1958 the first multinational treaty aimed at facilitating the enforcement of private international arbitral decisions in the national courts of sovereigns emerged: the United Nations New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. Since then, many, though not all, countries have signed the New York Convention (NYC)."

Their bottom line is that it is not necessary to have a government that rules outer space in order to have a recognized legal system for dispute resolution in outer space. They write:

Perhaps commercial space pioneers would use already-existing arbitration associations, such as the ICC, in order to enforce celestial property rights. Or perhaps a body of private outer space law—informed at its core by familiar precedents relating to nuisance, damages, liability, and so on—might progress to the point that space-specific arbitration agencies, employing their own experts in space law, would serve as the primary dispute resolution mechanism and process by which precedent is set. Alternatively, the first space pioneers might have a voluntary convention in which their representatives form a kind of outer space “social contract,” thereby setting the rules for original appropriation of unowned resources, property rights enforcement, and the proper bounds of behavior between parties when one party’s behavior imposes uncompensated burdens on others.

The Salter and Leeson argument is usefully mind-expanding about the potential for private property rights. But as they point out at the end of the article, their argument is essentially one of economics, not of politics. I can easily imagine the kind of regime that they describe as useful for thinking about issues that arise between those who are operating in outer space, applying to the times when they are operating in outer space.

But the first time resources or other resources from outer space are brought to Earth in sufficient quantities to be worth a lot of money, or to move prices of minerals in Earth-markets, I suspect that any agreements reached by those who were travelling in outer space will come under Earthly political challenge. Denmark recently announced that it was challenging Russia and Canada for control over the territory that includes the North Pole, and the United States and Greenland also have ongoing claims in Arctic waters. I suspect that nations will try to assert jurisdiction over outer space, too.

Thursday, December 25, 2014

Charles Dickens wrote what has become one of the iconic stories of Christmas day and Christmas spirit in "A Christmas Carol." But of course, the experiences of Ebenezer Scrooge are a story, not a piece of reporting. Yesterday, I offered an article by Charles Dickens about his views of "masters" and "hands" during a textile strike, written for the weekly journal Household Words that Dickens edited from 1850 to 1859. Here's another piece from Dickens from the journal from the issue of January 26, 1856, with his first-person reporting on "A Nightly Scene in London." Poverty in high-income countries is no longer as ghastly as in Victorian England, but for those who take the time to see it, it for our own time and place, surely it is ghastly enough.

Economists might also take note of Dickens's comment on the reactions to poverty by "the unreasonable disciples of a reasonable school, demented disciples who push arithmetic and political economy beyond all bounds of sense." He writes: "I know that the unreasonable disciples of a reasonable school, demented disciples who push arithmetic and political economy beyond all bounds of sense (not to speak of such a weakness as humanity), and hold them to be all-sufficient for every case, can easily prove that such things ought to be, and that no man has any business to mind them. Without disparaging those indispensable sciences in their sanity, I utterly renounce and abominate them in their insanity ..." Here's Dickens:

On the fifth of last November, I, the Conductor of this journal, accompanied by a friend well-known to the public, accidentally strayed into Whitechapel. It was a miserable evening; very dark, very muddy, and raining hard.

There are many woful sights in that part of London, and it has been well-known to me in most of its aspects for many years. We had forgotten the mud and rain in slowly walking along and looking about us, when we found ourselves, at eight o'clock, before the Workhouse.

Crouched against the wall of the Workhouse, in the dark street, on the muddy pavement-stones, with the rain raining upon them, were five bundles of rags. They were motionless, and had no resemblance to the human form. Five great beehives, covered with rags— five dead bodies taken out of graves, tied neck and heels, and covered with rags— would have looked like those five bundles upon which the rain rained down in the public street.

"What is this! " said my companion. "What is this!"

"Some miserable people shut out of the Casual Ward, I think," said I.

We had stopped before the five ragged mounds, and were quite rooted to the spot by their horrible appearance. Five awful Sphinxes by the wayside, crying to every passer-by, " Stop and guess! What is to be the end of a state of society that leaves us here!"

As we stood looking at them, a decent working-man, having the appearance of a stone-mason, touched me on the shoulder.

"This is an awful sight, sir," said he, "in a Christian country!"

"GOD knows it is, my friend," said I.

"I have often seen it much worse than this, as I have been going home from my work. I have counted fifteen, twenty, five-and-twenty, many a time. It's a shocking thing to see."

"A shocking thing, indeed," said I and my companion together. The man lingered near
us a little while, wished us good-night, and went on.

We should have felt it brutal in us who had a better chance of being heard than the working-man, to leave the thing as it was, so we knocked at the Workhouse Gate. I undertook to be spokesman. The moment the gate was opened by an old pauper, I went in, followed close by my companion. I lost no
time in passing the old porter, for I saw in his watery eye a disposition to shut us out.

"Be so good as to give that card to the master of the Workhouse, and say I shall be glad to speak to him for a moment."

We were in a kind of covered gateway, and the old porter went across it with the card. Before he had got to a door on our left, a man in a cloak and hat bounced out of it very sharply, as if he were in the nightly habit of being bullied and of returning the compliment.

"Now, gentlemen," said he in a loud voice, "what do you want here?"

"First," said I, " will you do me the favor to look at that card in your hand. Perhaps you may know my name."

"Yes," says he, looking at it. " I know this name."

"Good. I only want to ask you a plain question in a civil manner, and there is not the least occasion for either of us to be angry. It would be very foolish in me to blame you, and I don't blame you. I may
find fault with the system you administer, but pray understand that I know you are here to do a duty pointed out to you, and that I have no doubt you do it. Now, I hope you won't object to tell me what I want to know."

"No," said he, quite mollified, and very reasonable, " not at all. What is it ?"

"Do you know that there are five wretched creatures outside?"

"I haven't seen them, but I dare say there are."

"Do you doubt that there are?"

"No, not at all. There might be many more."

''Are they men? Or women?"

"Women, I suppose. Very likely one or two of them were there last night, and the night before last."

"There all night, do you mean?"

"Very likely."

My companion and I looked at one another, and the master of the Workhouse added quickly, " Why, Lord bless my soul, what am I to do? What can I do ? The place is full. The place is always full—every night. I must give the preference to women with children, mustn't I? You wouldn't have me not do that?"

"Surely not," said I. "It is a very humane principle, and quite right; and I am glad to hear of it. Don't forget that I don't blame you."

"Well!" said he. And subdued himself again.

"What I want to ask you," I went on, " is whether you know anything against those five miserable beings outside?"

"Don't know anything about them," said he, with a wave of his arm.

"I ask, for this reason: that we mean to give them a trifle to get a lodging— if they are not shelterless because they are thieves for instance.—You don't know them to be thieves ?"

"I don't know anything about them," he repeated emphatically.

"That is to say, they are shut out, solely because the Ward is full?"

"Because the Ward is full."

"And if they got in, they would only have a roof for the night and a bit of bread in the morning, I suppose?"

"That's all. You'll use your own discretion about what you give them. Only understand that I don't know anything about them beyond what I have told you."

"Just so. I wanted to know no more. You have answered my question civilly and readily, and I am much obliged to you. I have nothing to say against you, but quite the contrary. Good night!"

"Good night, gentlemen!" And out we came again.

We went to the ragged bundle nearest to the Workhouse-door, and I touched it. No movement replying, I gently shook it. The rags began to be slowly stirred within, and by little and little a head was unshrouded. The head of a young woman of three or four and twenty, as I should judge; gaunt with want, and foul with dirt; but not naturally ugly.

"Tell us," said I, stooping down. "Why are you lying here?"

"Because I can't get into the Workhouse."

She spoke in a faint dull way, and had no curiosity or interest left. She looked dreamily at the black sky and the falling rain, but never looked at me or my companion.

"Were you here last night?"

"Yes, All last night. And the night afore too."

"Do you know any of these others?"

"I know her next but one. She was here last night, and she told me she come out of Essex. I don't know no more of her."

"You were here all last night, but you have not been here all day?"

"No. Not all day."

"Where have you been all day?"

"About the streets."

''What have you had to eat?"

"Nothing."

"Come!" said I. "Think a little. You are tired and have been asleep, and don't quite consider what you are saying to us. You have had something to eat to-day. Come! Think of it!"

"No I haven't. Nothing but such bits as I could pick up about the market. Why, look at me!"

She bared her neck, and I covered it up again.

"If you had a shilling to get some supper and a lodging, should you know where to get it?"

"Yes. I could do that."

"For GOD'S sake get it then!"

I put the money into her hand, and she feebly rose up and went away. She never thanked me, never looked at me— melted away into the miserable night, in the strangest manner I ever saw. I have seen many strange things, but not one that has left a deeper impression on my memory than the dull impassive way in which that worn-out heap of misery took that piece of money, and was lost.

One by one I spoke to all the five. In every one, interest and curiosity were as extinct as in the first. They were all dull and languid. No one made any sort of profession or complaint; no one cared to look at me; no one thanked me. When I came to the third, I suppose she saw that my companion
and I glanced, with a new horror upon us, at the two last, who had dropped against each other in their sleep, and were lying like broken images. She said, she believed they were young sisters. These were the only words that were originated among the five.

And now let me close this terrible account with a redeeming and beautiful trait of the poorest of the poor. When we came out of the Workhouse, we had gone across the road to a public house, finding ourselves without silver, to get change for a sovereign. I held the money in my hand while I was speaking to the five apparitions. Our being so engaged, attracted the attention of many people of the very poor sort usual to that place; as we leaned over the mounds of rags, they eagerly leaned over us to see and hear; what I had in my hand, and what I said, and what I did, must have been plain to nearly all the concourse. When the last of the five had got up and faded away, the spectators opened to let us pass; and not one of them, by word, or look, or gesture, begged of us.

Many of the observant faces were quick enough to know that it would have been a relief to us to have got rid of the rest of the money with any hope of doing good with it. But, there was a feeling among them all, that their necessities were not to be placed by the side of such a spectacle; and they opened a
way for us in profound silence, and let us go.

My companion wrote to me, next day, that the five ragged bundles had been upon his bed all night. I debated how to add our testimony to that of many other persons who from time to time are impelled to write to the newspapers, by having come upon some shameful and shocking sight of this description. I resolved to write in these pages an exact account of what we had seen, but to
wait until after Christmas, in order that there might be no heat or haste. I know that the unreasonable disciples of a reasonable school, demented disciples who push arithmetic and political economy beyond all bounds of sense (not to speak of such a weakness as humanity), and hold them to be all-
sufficient for every case, can easily prove that such things ought to be, and that no man has
any business to mind them. Without disparaging those indispensable sciences in their sanity, I utterly renounce and abominate them in their insanity; and I address people with a respect for the spirit of the New Testament, who do mind such things, and who think them infamous in our streets.

Wednesday, December 24, 2014

There's a sort of parlor game that the economically-minded sometimes play around the Christmas holiday, related to A Christmas Carol, by Charles Dickens. Was Dickens writing his story as an attack on economics, capitalism, and selfishness? After all, his depiction of Ebenezer Scrooge, along with his use of phrases like "decrease the surplus population" and "a good man of business" would suggest as much, and a classic example of such an interpretation is here. Or was Dickens just telling a good story with distinct characters? After all, Scrooge is portrayed as an outlier in the business community. The warm portrayal of Mr. Fezziwig certainly opens the possibility that one can be a successful man of business as well as a good employer and a decent human being. And if Scrooge hadn't saved money, would he have been able to save Tiny Tim? It's all a good "talker," as they say about the topics that get kicked around on radio shows every day.

I went looking for some other perspectives on how Charles Dickens perceived capitalism that were not embedded in a fictional setting. In particular, I checked the weekly journal Household Words, which Dickens edited from 1850 to 1859. Articles in Household Words do not have authors provided. However, Anne Lohrli went through the business and financial records of the publication, which identified the authors and showed who had been paid for each article. The internal records of the journal show that Dickens was the author of this piece from the issue of February 11, 1854, called "On Strike." (Lohrli's book is called Household Words: A Weekly Journal 1850-59, conducted by Charles Dickens, University of Toronto Press, 1973. Household Words is freely available on-line at at site hosted by the University of Buckingham, with support from the Leverhulme Trust and other donors.)

The article does not seem especially well-known today, but it is the source of a couple of the most common quotations from Charles Dickens about "political economy," as the study of economics was usually called at the time. Early in the piece, Dickens wrote: ""Political Economy was a great and useful science in its own way and its own place; but ... I did not transplant my definition of it from the Common Prayer Book, and make it a great king above all gods." Later in the article, he wrote: "[P]olitical economy is a mere skeleton unless it has a little human covering andfilling out, a little human bloom upon it, and a little human warmth in it."

But more broadly, the article is of interest because Dickens, telling the story in the first person, takes the position that in thinking about a strike taking place in the town of Preston, one need not take the side either of the masters or of the hands. Instead, Dickens writes, one may "be a friend to both," and feel that the strike is "to be deplored on all accounts." Of course, the problem with a middle-of-the-road position is that you can end up being hit by ideological traffic going in both directions. But the ability of Dickens to sympathize with people in a wide range of positions is surely part what gives his novels and his world-view such lasting power. The article goes into a fair amount of detail, and can be read on-line, so I will content myself here with what is still a fairly lengthy excerpt. Here's Dickens:

Travelling down to Preston a week from this date, I chanced to sit opposite to a very acute, very determined, very emphatic personage, with a stout railway rug so drawn over his chest that he looked as if he were sitting up in bed with his great coat, hat, and gloves on, severely contemplating your humble servant from behind a large blue and grey checked counterpane. In calling him emphatic, I do
not mean that he was warm; he was coldly and bitingly emphatic as a frosty wind is.

"You are going through to Preston, sir?" says he, as soon as we were clear of the
Primrose Hill tunnel.

The receipt of this question was like the receipt of a jerk of the nose; he was so short and sharp.

"Yes."

"This Preston strike is a nice piece of business!" said the gentleman. "A pretty piece of business!"

"It is very much to be deplored," said I, "on all accounts."

"They want to be ground. That's what they want to bring 'em to their senses," said the gentleman; whom I had already began to call in my own mind Mr. Snapper, and whom I may as well call by that name here as by any other. *

I deferentially enquired, who wanted to be ground?

"The hands," said Mr. Snapper. " The hands on strike, and the hands who help 'em."

I remarked that if that was all they wanted, they must be a very unreasonable people, for surely they had had a little grinding, one way and another, already. Mr. Snapper eyed me with sternness, and after opening and shutting his leathern-gloved hands several times outside his counterpane, asked me
abruptly, " Was I a delegate?"

I set Mr. Snapper right on that point, and told him I was no delegate.

"I am glad to hear it," said Mr. Snapper. "But a friend to the Strike, I believe?"

"Not at all," said I.

"A friend to the Lock-out?" pursued Mr. Snapper.

"Not in the least," said I,

Mr. Snapper's rising opinion of me fell again, and he gave me to understand that a man must either be a friend to the Masters or a friend to the Hands.

"He may be a friend to both," said I.

Mr. Snapper didn't see that; there was no medium in the Political Economy of the subject. I retorted on Mr. Snapper, that Political Economy was a great and useful science in its own way and its own place; but that I did not transplant my definition of it from the Common Prayer Book, and make it a great king above all gods. Mr. Snapper tucked himself up as if to keep me off, folded his arms on the top of his counterpane, leaned back and looked out of the window.

"Pray what would you have, sir," enquire Mr. Snapper, suddenly withdrawing his eyes from the prospect to me, "in the relations between Capital and Labour, but Political Economy?"

I always avoid the stereotyped terms in these discussions as much as I can, for I have observed, in my little way, that they often supply the place of sense and moderation. I therefore took my gentleman up with the words employers and employed, in preference to Capital and Labour.

"I believe," said I, "that into the relations between employers and employed, as into all the relations of this life, there must enter something of feeling and sentiment; something of mutual explanation, forbearance, and consideration; something which is not to be found in Mr. M'CulIoch's dictionary, and is not exactly stateable in figures; otherwise those relations are wrong and rotten at the core and will never bear sound fruit."

Mr. Snapper laughed at me. As I thought I had just as good reason to laugh at Mr. Snapper, I did so, and we were both contented.

"Ah!" said Mr. Snapper, patting his counterpane with a hard touch. " You know very little of the improvident and unreasoning habits of the common people, I see."

"Yet I know something of those people too," was my reply. " In fact Mr. ——," I had so nearly called him Snapper! "in fact, sir, I doubt the existence at this present time of many faults that are merely class faults. In the main, I am disposed to think that whatever faults you may find to exist, in your
own neighbourhood for instance, among the hands, you will find tolerably equal in amount among the masters also, and even among the classes above the masters. They will be modified by circumstances, and they will be the less excusable among the better-educated, but they will be pretty fairly distributed. I have a strong expectation that we shall live to see the conventional adjectives now
apparently inseparable from the phrases working people and lower orders, gradually fall into complete disuse for this reason."

"Well, but we began with strikes," Mr. Snapper observed impatiently. " The masters have never had any share in strikes."

"Yet I have heard of strikes once upon a time in that same county of Lancashire," said I, " which were not disagreeable to some masters when they wanted a pretext for raising prices."

"Do you mean to say those masters had any hand in getting up those strikes?" asked Mr. Snapper.

"You will perhaps obtain better information among persons engaged in some Manchester
branch trades, who have good memories," said I.

Mr. Snapper had no doubt, after this, that I thought the hands had a right to combine?

"Surely," said I. " A perfect right to combine in any lawful manner. The fact of their being able to combine and accustomed to combine may, I can easily conceive, be a protection to them. The blame even of this business is not all on one side. I think the associated Lock-out was a grave error. And
when you Preston masters—"

"I am not a Preston master," interrupted Mr. Snapper.

"When the respectable combined body of Preston masters," said I, " in the beginning of this unhappy difference, laid down the principle that no man should be employed henceforth who belonged to any combination—such as their own—they attempted to carry with a high hand a partial and unfair impossibility, and were obliged to abandon it. This was an unwise proceeding, and the first defeat."

Mr. Snapper had known, all along, that I was no friend to the masters.

"Pardon me," said I; " I am unfeignedly a friend to the masters, and have many friends among them."

"Yet you think these hands in the right?" quoth Mr. Snapper.

"By no means," said I; " I fear they are at present engaged in an unreasonable struggle, wherein they began ill and cannot end well."

Mr. Snapper, evidently regarding me as neither fish, flesh, nor fowl, begged to know after a pause if he might enquire whether I was going to Preston on business?

Indeed I was going there, in my unbusinesslike manner, I confessed, to look at the strike.

"To look at the strike!" echoed Mr. Snapper fixing his hat on firmly with both hands. "To look at it! Might I ask you now, with what object you are going to look at it?"

"Certainly," said I. " I read, even in liberal pages, the hardest Political Economy—of an extraordinary description too sometimes, and certainly not to be found in the books—as the only touchstone of this strike. I see, this very day in a to-morrow's liberal paper, some astonishing novelties in the politico-economical way, showing how profits and wages have no connexion whatever; coupled with such references to these hands as might be made by a very irascible General to rebels and brigands in arms. Now, if it be the case that some of the highest virtues of the working people still shine through them brighter than ever in their conduct of this mistake of theirs, perhaps the fact may reasonably suggest to me—and to others besides me—that there is some little things wanting in the relations between them and their employers, which neither political economy nor Drum-head proclamation writing will altogether supply, and which we cannot too soon or too temperately unite in trying to
find out."

Mr. Snapper, after again opening and shutting his gloved hands several times, drew the counterpane higher over his chest, and went to bed in disgust. He got up at Rugby, took himself and counterpane into another carriage, and left me to pursue my journey alone.

When I got to Preston, it was four o'clock in the afternoon. The day being Saturday and market-day, a foreigner might have expected, from among so many idle and not over-fed people as the town contained, to find a turbulent, ill-conditioned crowd in the streets. But, except for the cold smokeless
factory chimneys, the placards at the street corners, and the groups of working people attentively reading them, nor foreigner, nor Englishman could have had the least suspicion that there existed any interruption to the usual labours of the place. The placards thus perused were not remarkable for their
logic certainly, and did not make the case particularly clear; but, considering that they emanated from, and were addressed to, people who had been out of employment for three- and-twenty consecutive weeks, at least they had little passion in them though they had
not much reason.

Take the worst I could find:

"Friends and Fellow Operatives,

"Accept the grateful thanks of twenty thousand struggling Operatives, for the help you have showered upon Preston since the present contest commenced. ...

"The earth was not made for the misery of its people; intellect was not given to man to make himself and fellow creatures unhappy. No, the fruitfulness of the soil and the wonderful inventions —the result of mind—all proclaim that these things were bestowed upon us for our happiness and well-being, and not for the misery and degradation of the human race.

"It may serve the manufacturers and all who run away with the lion's share of labour's produce, to say that the impartial God intended that there should be a partial distribution of his blessings. But we know that it is against nature to believe, that those who plant and reap all the grain, should not have enough to make a mess of porridge; and we know that those who weave all the cloth should not want a yard to cover their persons, whilst those who never wove an inch have more calico, silks and satins, than would serve the reasonable wants of a dozen working men and their families.

"This system of giving everything to the few, and nothing to the many, has lasted long enough, and we call upon the working people of this country to be determined to establish a new and improved system—a system that shall give to all who labour, a fair share of those blessings and comforts which their toil produce; in short, we wish to see that divine precept enforced, which says, ' Those who will not work, shall not eat.'

"The task is before you, working men; if you think the good which would result from its
accomplishment, is worth struggling for, set to work and cease not, until you have obtained the good time coming, not only for the Preston Operatives, but for yourselves as well.

It is a melancholy thing that it should not occur to the Committee to consider what would become of themselves, their friends, and fellow operatives, if those calicoes, silks, and satins, were not worn in very large quantities; but I shall not enter into that question. As I had told my friend Snapper, what I
wanted to see with my own eyes, was, how these people acted under a mistaken impression, and what qualities they showed, even at that disadvantage, which ought to be the strength and peace—not the weakness and trouble—of the community. I found, even from this literature, however, that all
masters were not indiscriminately unpopular. Witness the following verses from the New
Song of the Preston Strike:

"There's Henry Hornby, of Blackburn, he is a jolly brick,
He fits the Preston masters nobly, and is very bad to trick;
He pays his hands a good price, and I hope he will never sever,
So we'll sing success to Hornby and Blackburn for ever.

"There is another gentleman, I'm sure you'll all lament,
In Blackburn for him they're raising a monument,
You know his name, 'tis of great fame, it was late Eccles of honour,
May Hopwood, and Sparrow, and Hornby live for ever.
"So now it is time to finish and end my rhyme,

We warn these Preston Cotton Lords to mind for future time.
With peace and order too I hope we shall be clever,
We sing success to Stockport and Blackburn for ever.
" Now, lads, give your minds to it."

...

The Masters' placards were not torn down or disfigured, but were being read quite as attentively as those on the opposite side. ... Neither by night nor by day was there any interruption to the peace of the streets. Nor was this an accidental state of things, for the police records of the town are eloquent to the same effect. I traversed the streets very much, and was, as a stranger, the subject of a little curiosity among the idlers; but I met with no rudeness or ill-temper. More than once, when I was looking at the printed balance-sheets to which I have referred, and could not quite comprehend the setting forth of the figures, a bystander of the working class interposed with his explanatory
forefinger and helped me out. ...

In any aspect in which it can be viewed, this strike and lock-out is a deplorable calamity. In its waste of time, in its waste of a great people's energy, in its waste of wages, in its waste of wealth that seeks to be employed, in its encroachment on the means of many thousands who are labouring from day
to day, in the gulf of separation it hourly deepens between those whose interests must be understood to be identical or must be destroyed, it is a great national afliiction. But, at this pass, anger is of no use, starving out is of no use—for what will that do, five years hence, but overshadow all the mills in
England with the growth of a bitter remembrance? —political economy is a mere skeleton unless it has a little human covering and filling out, a little human bloom upon it, and a little human warmth in it. Gentlemen are found, in great manufacturing towns, ready enough to extol imbecile mediation with dangerous madmen abroad; can none of them be brought to think of authorised mediation
and explanation at home? I do not suppose that such a knotted difficulty as this, is to be at all untangled by a morning-party in the Adelphi; but I would entreat both sides now so miserably opposed, to consider whether there are no men in England above suspicion, to whom they might refer the matters in dispute, with a perfect confidence above all things in the desire of those men to act justly, and in their sincere attachment to their countrymen of every rank and to their country.
Masters right, or men right; masters wrong, or men wrong; both right, or both wrong; there is certain ruin to both in the continuance or frequent revival of this breach. And from the ever-widening circle of their decay, what drop in the social ocean shall be free!

Tuesday, December 23, 2014

Nobel prizes in economics are only given to living people. In addition, because it often takes some time to determine whether certain research is truly important, the Nobel prize of goes to older scholars: for example, the 2014 Nobel laureate Jean Tirole was 61 at the time of the award: the ages of the 2013 winners, at the time they won the prize, were Eugene Fama, 74; Lars Peter Hansen, 61; and Robert J. Schiller, 67; while the ages of the 2012 winners at the time of the award were Alvin Roth, 61, and Lloyd Shapley, 89

So what's the top research prize going to younger economists? The John Bates Clark medal is a prize given by the American Economic Association "to that American economist under the age of forty who is judged to have made the most significant contribution to economic thought and knowledge." In other words, it highlights a scholar who has already been doing the kind of work for which--who knows?--a Nobel prize might be awarded in a few more decades. As you might imagine, the leading contenders for the Clark medal are usually in their late 30s, rather than a few years younger. in part because the extra few years means that there has been more time to publish research, and in part because there is a feeling that those their early 30s, even if already worthy of the award, will still be eligible in a few more years. Thus, it is a sign of the high regard in which Raj Chetty's work is already held that he was awarded the Clark medal in 2013 when he was 33 years old.

"How can we measure and improve, possibly, the quality of teachers in public schools in America? We tackled that question by getting data from one of the biggest urban school districts in the United States, on 2½ million children over a 20-year period, during which they wrote 18 million tests.

"We take that data, which tells us how students did in math and English, what teachers they had, which classrooms they were assigned to and so forth, and link that to administrative records from tax returns and social security databases on students’ earnings, college attendance outcomes and various other markers of success later in life. So, essentially, the type of question we are able to ask is, how did the third-grade teacher that you had affect your success 25 years later? ... If you’re assigned a high value-added teacher in third grade—that is, the teacher who is systematically improving test scores—and I happen to get a low value-added teacher, does that impact last? Are you, in fact, doing better many years later, or are we both doing as well as each other?

"The prior literature in education would lead us to think that these impacts are not that long lasting. Many studies have shown that test score gains tend to “fade out” over time. What that means is that if a child is assigned to a better teacher in third grade, we see her doing better on third grade tests, but a lot of that gain shrinks by the end of fourth grade and virtually disappears by fifth or sixth grade. Based on that evidence, you might have thought, well, by the time we’re looking at people’s earnings years later, so many other things have happened in their lives, and we’re not really going to find a meaningful effect of these teachers. ... And so going into this work, our prior assumption was we might find something, but more likely we might not find any lasting impact, which would also be useful to know. So we were very curious to look at the data.

"Much to our surprise, it immediately became evident that students who were assigned to high value-added teachers showed substantially larger gains in terms of earnings, college attendance rates, significantly lower teenage birth rates; they lived in better neighborhoods as adults; they had higher levels of retirement savings. Across a broad spectrum of outcomes, there were quite substantial and meaningful impacts on children’s long-term success, despite seeing the same fade-out pattern for test scores."

Intergenerational Mobility

"How has intergenerational mobility changed over time in America, and how does it vary across places within the U.S.? There’s a popular conception that the U.S. once was a great land of opportunity and that that’s no longer true today. Unfortunately, we’ve had relatively little data to actually be able to study the degree of social mobility systematically in the United States, so it is has been hard to know whether this conception is accurate or not.

"When we actually looked at the data over the past 30 to 40 years or so—a period for which we have good information from de-identified tax returns on children’s parents’ income as well as their own income—we find that, much to our surprise, there isn’t that much of a difference in social mobility in the United States today relative to kids who were entering the labor force in, say, the 1970s or 1980s. That is, children’s odds of moving up or down in the income distribution relative to their parents have not changed a whole lot in the past few decades.

"We find that where there is much more variation is across space rather than over time. ... For example, for children growing up in places like Salt Lake City, Utah, or San Jose, California, the odds of moving from the bottom fifth of the national income distribution to the top fifth are more than 12 percent or even 14 percent in some cases, more than virtually any other developed country for which we have data. In contrast, in cities like Charlotte, North Carolina, Atlanta, Georgia, or Indianapolis, Indiana, a child’s odds of moving from the bottom fifth to the top fifth are less than 5 percent—less than any developed country for which we currently have data. ...

"We’re studying 20 million families that moved with their kids between metro areas of the United States. We ask if you move, say, as a 5-year-old, from Atlanta to Salt Lake City, do your outcomes improve? Do you look more like the kids who grew up in Salt Lake City and did really well? And secondly, how does that play out, depending uponwhen you moved? If you moved when you were 10 years old or 15 years old, rather than as a 5-year-old, do you get less of the benefit? One of the intriguing preliminary findings from this work is that there’s a linear “exposure effect.” Every extra year you spend in a better environment, your own outcomes improve and converge to the outcomes of the prior residents. This type of evidence strongly suggests that the differences in upward mobility across places are actually a causal effect of growing up in, say, Salt Lake City rather than Atlanta, as opposed to just differences in the types of people who live in Salt Lake City versus Atlanta."

The interview introduces some other prominent work by Chetty, as well. For example, there was the study of tax "salilence," to see whether people pay attention to sales taxes. The researchers labelled a selection of about 1,000 products in a story with a label that showed the price plus the sales tax. In theory, this should make no difference to consumer behavior: after all, doesn't everyone already know that you will need to pay sales tax at the register? But in practice, showing the higher price with the sales tax caused sales of that product to decline. This finding also suggests that sales taxes might change purchasing behavior less than one might expect--because a lot of people are largely ignoring them.

As another example, there's a well-known empirical finding that when people have more generous unemployment insurance, they are on average slower to find a new job. The standard economic explanation for this pattern had been that when people have more generous unemployment benefits, they don't look as hard for a new job. The implication is that many unemployed people could take suitable jobs sooner, if they were motivated to do so. Chetty suggested the possibility of another explanation: perhaps unemployed people are looking for a good job match--that is, a job that reflects their skills and experience. More generous unemployment benefits give them a chance to search for longer period, thus raising their chance of a good job match. Here, the implication is that many unemployed people do not have a suitable job match that is readily available, but that those who run out of funds--because of less generous unemployment insurance--are then pressured by sheer lack of income to take a less suitable job.

How might one distinguish between these hypotheses? Chetty looked at data on the savings of the unemployed. Imagine a people in different states who have differing levels of unemployment benefits, but some have higher savings and some have lower savings. It turns out that when those with more saving have more generous unemployment insurance, the negative effect on their finding a job is much lower. Chetty says: "I end up concluding that something like two-thirds of the relationship between unemployment benefits and unemployment rates, is actually due to a liquidity effect, rather than a distortionary moral hazard effect." In other words, many of the unemployed are looking for a good job match, but if they have little savings, they are more likely to run out of funds before they can find it. More generous unemployment insurance helps the unemployed wait a little longer for a better job match, which is ultimately better for the worker and the economy.

If you aspire to follow economics and economic news, get familiar with Chetty's name and work. You'll probably be hearing about it for the next few decades.

Monday, December 22, 2014

The U.S. corporate income tax always seems controversial. Are U.S. corporations taxed too little? Are they taking jobs and business outside the U.S. because they are taxed too much? Should the goal be to eliminate the corporate tax and instead focus on how we tax those who benefit from higher corporate profits through dividends and capital gains on stock ownership? But while we are having these arguments, an increasing number of U.S. firms are organizing themselves as "flow-through" businesses, in which the corporate tax does not apply to profits, because the profits flow immediately through to owners.

More than 90 percent of businesses, representing more than one-third of all business activity, in the United States are structured as flow-through entities — businesses that do not pay the corporate income tax, but rather pass profits through to owners who pay tax under the individual income tax. Over the past two decades, the importance of flow-through businesses — partnerships and S corporations in particular — has grown dramatically. In 2012 net income from sole proprietorships, partnerships, and S corporations totaled nearly $840 billion and accounted for more than 9 percent of
total adjusted gross income reported on individual income tax returns. ... [I]income from partnerships and S corporations has more than tripled as a share of AGI since the late 1980s.

For another perspective, here's some data on the share of net business income generated by the type of business, from a 2013 report by Mark P. Keightley for the Congressional Research Service. Back in 1980, nearly 80% of business income went to "C" corporations--so named after the applicable part of the tax code that governs them--which are what most of us think of when we think of a "corporation." Back then, the remaining 20% was almost all sole proprietorships, which were just taxed as individual income.

But C corporations now account for only about 30% of all business income. The share going to sole proprietorships hasn't changed much. But much more corporate income is going to partnership and S corporations. Keightley explains an S-corporation this way:

An S corporation is a “closely held” corporation that elects to be treated as a pass-through entity for tax purposes. S corporations are named for Subchapter S of the IRC, which details their tax treatment. By electing S corporation status, a business is able to combine many of the legal and business advantages of a C corporation with the tax advantages of a partnership. Several criteria must be met if a corporation wishes to elect S corporation status. The corporation must be incorporated and organized in the United States. An S corporation can only issue one class of stock and is limited to no more than 100 shareholders. The shareholders must be individuals, estates, certain types of trusts, tax-exempt pension funds, or charitable organizations. All shareholders must be U.S. citizens or residents.

The Congressional Budget Office looks at some of the reasons underlying the move away from C corporations and toward S corporations in its December 2012 report, "Taxing Businesses Through the Individual Income Tax." The CBO points out that a shift toward service industries in recent decades is part of the change, since a number of service industries find it relatively easy to organize as partnerships or S-corporations. Reductions in top tax rates for individuals made receiving business income as an individual more attractive. Tax laws were also changed to increase the maximum number of shareholders there could be in an S-corporation from 35 to 75 in 1997, and then from 75 to 100 in 2005.

Back in the 1960s, the corporate income tax often collected 4-5% of GDP. Since about 1990, it has more commonly collected 1-2% of GDP. Part of the reason is that a smaller share of business income is flowing through the conventional C corporation form. For example, the CBO estimates that if the C-corporation tax rules had been applied to the income from S corporations and limited liability partnerships in 2007, total federal tax revenues would have been $76 billion higher. The CBO estimates that the movement to S corporations and partnerships may have somewhat longer to run. When firms see a way to organize themselves as flow-through organizations that can avoid the corporate income tax, as in the case of partnerships and S corporations, they have been increasingly aggressive about doing so.

But the underlying issue here is the need for reform of how the U.S. taxes corporations. A standard problem that economists point to is that corporate dividends are taxed twice: once as corporate profits, and then again as individual income when they are passed to shareholders. Flow-through firms avoid this problem by just having profits flow out of the organization each year, and then taxing those profits as individual income. But many corporations hold on to a lot of the profits that they earn and reinvest them in the company. It makes sense to apply a corporate tax to those kinds of firms, because otherwise, it would be possible for people to plow back their income into the corporation each year and escape taxation in that way. It's a complicated business to think about how flow-through ideas might be applied to modern C corporations, but it's a discussion that's overdue.

Saturday, December 20, 2014

Earlier this week I offered some "Snapshots of Islamic Banking" with a global perspective. I then learned about "Islamic Banking, American Regulation," by Renee Haltom, published in Econ Focus from the Federal Reserve Bank of Richmond. The focus of Haltom's article is n the subtitle to her article: "For some American Muslims, Sharia-compliant banks are an important part of the financial landscape." As I read Haltom's article, I was struck by some of the claims concerning whether, at least in cases, Islamic banks--including those in US markets--are mostly just relabelling the same flows of capital, with essentially the same risk characteristics, as conventional banks. Here's Haltom describing the presence of Islamic banking in the U.S. market:

"The United States’ Muslim population is roughly equal to that of the United Kingdom, a country that houses $19 billion in Islamic financial institution assets, more than 20 banks, and six that provide Sharia-compliant products exclusively. Yet our market for Islamic financial products is much smaller. There's no single list of participating firms or aggregate estimate of assets, but one can find roughly a dozen firms that routinely offer Islamic banking and investment products to businesses and consumers, though several don’t even market such products on their websites. ...

Islamic finance came to the United States in the 1980s when two institutions opened on the West Coast. ... The institutions operational today provide services in several states, most prevalently where the Muslim population is concentrated. University Islamic Financial (a subsidiary of University Bank) based in Ann Arbor, Mich., serving the large Muslim population of metropolitan Detroit and surrounding states, is the first and only exclusively Sharia-compliant bank in the United States — it offers no other products. Devon Bank in Chicago is the only other bank regularly offering Islamic financing products. Reston, Va.- based Guidance Residential is the largest nonbank financial institution offering Islamic finance services, having provided more than $3 billion — which it claims is nearly 80 percent of the total — in musharaka mortgage financing in 22 states since its doors opened in 2002. California-based LARIBA is another large Islamic mortgage lender, and it also provides business financing.

To what extent are Islamic banks different from conventioanl banks? Haltom cites some of the evidence:

"To critics, Islamic finance is a distinction without a difference. According to research by Feisal Khan, an economics professor at Hobart and William Smith Colleges in upstate New York, most Islamic finance transactions are economically indistinguishable from traditional, debt- and interest-based finance. Where there is principal and a payment plan, there is an implied interest rate, Khan argued in a 2010 article. He is not the first economist to make such a claim. Many Islamic scholars argue that murabaha contracts don't share risk and thus are not Sharia-compliant — and experts estimate that such contracts constitute up to 80 percent of the global Islamic finance volume. Other economists have noted that the terms of Islamic financial contracts often move with market interest rates. In the United States, Islamic financial products are frequently marketed with information about implied interest rates to allow customers to compare prices or simply to comply with American regulation. A study of Malaysia, the world's largest Islamic finance market, found that Islamic deposit rates fluctuate in step with market interest rates."

U.S. financial authorities seem to agree.

Banks here [in the U.S.] are normally prohibited from taking on partnership or equity stakes in real estate, a provision meant to limit speculation. But in Islamic finance, the bank assumes formal ownership. Regulators in the United States have held, however, that Islamic finance is compatible with the prohibition on real estate investments in some cases. In 1997, the United Bank of Kuwait (UBK), which then had a branch in New York, requested interpretive letters from its regulator, the Office of the Comptroller of the Currency (OCC), on ijara and murabaha mortgage products. The OCC approved them on the very grounds that they were economically equivalent to traditional products.

In the OCC's view, because the purchase and sale transactions are executed simultaneously, the bank's ownership is merely for "a moment in time," and therefore the Islamic contracts avoid the type of risk that real estate restrictions were intended to limit. (The joint ownership that defines musharaka contracts, on the other hand, is not currently approved for use by banks and is used in the United States only by nonbank mortgage lenders.) From an accounting standpoint, the transaction appears as a loan (an asset) on the bank's balance sheet. The borrower is responsible for maintaining the property and paying all expenses, and in the event of default, the bank may sell it to recover what is owed, as in a mortgage. ...

Possibly because the products are unfamiliar to many investors, there is a smaller secondary market for Islamic financial products, so it has been harder for Islamic mortgage lenders to remain liquid, hindering the market's growth. In the United States, housing agencies Freddie Mac and Fannie Mae started buying Islamic mortgage products in 2001 and 2003, respectively, to provide liquidity, and they are now the primary investors in Islamic mortgages. By 2007, one firm, Guidance Residential, was relying on more than $1 billion in financing from Freddie Mac. ...

Of course, there are a wide range of Islamic banks around the world, and they have a range of practices, so generalizations about the extent to which they are or are not similar to conventional banks are likely to be hazardous. But as Islamic banking grows, it will be interesting to watch whether it seems to be seeking ways to mimic conventional banking, albeit with different labels, or whether it is leading to greater use of financial contracts with distinctive risk-sharing properties. As one exmaple, there now appears to be an emerging market for Islamic bonds, called sukuk. Rather than being based on an explicit interest rate, they are tied to payment streams from tangible assets. Haltom explains:

In the 1990s, the first international accounting standards were developed for Islamic finance, and the first market emerged for Islamic bonds. Those bonds, called sukuk, tie investments to tangible assets that issue payment streams based on their revenues, much like securitized equity financing. ...

Another factor is that non-Muslim governments are moving toward issuing sukuk to draw the investment of oil-rich Muslim countries. In June, the United Kingdom issued more than $330 million in sukuk — compared with more than $100 billion in global sukuk offerings in 2013 — becoming the first country outside the Islamic world to do so. Prime Minister David Cameron said he wanted to make London "one of the great capitals of Islamic finance anywhere in the world." Luxembourg, Hong Kong, and South Africa have announced plans for their own offerings. Sukuk may also provide liquid assets to help domestic Islamic banks manage their balance sheets.

Friday, December 19, 2014

My family always had real Christmas trees when I was growing up. I've always had real trees as an adult. Living in my own little bubble, it thus came as a shock to me to learn that, of the households that have Christmas trees, over 80% use an artificial tree, according to Nielsen survey results commissioned by the American Christmas Tree Association (which largely represents sellers of artificial trees). But in a holiday season where the focus is often on whether we are naughty or nice, what choice of tree has greater environmental impact?

(Note: This post first appeared on December 24, 2012. It has been slightly edited.)

Here are some of the main messages I take away from these studies:

1) One artificial tree has greater environmental impact than one natural tree. However, an artificial tree can also be re-used over a number of years. Thus, there is some crossover point, if the artificial tree is used for long enough, that its environmental effect is less than an annual series of trees. For example, the ellipsos study finds that an artificial tree would need to be used for 20 years before its greenhouse gas effects would be less than those of an annual series of natural trees. The PE Americas study offers a wide range of scenarios, and summarizes, but here is the situation "for the base case when individual car transport distance for tree purchase is 2.5 miles each way. Because the natural tree provides an environmental benefit in terms of Global Warming Potential when landfilled, and Eutrophication Potential when composted or incinerated, there is no number of years one can keep an artificial tree in order to match the natural tree impacts in these cases. ... For all other scenarios, the artificial tree has less impact provided it is kept and reused for a minimum between 2 and 9 years, depending upon the environmental indicator chosen."

2) The full analysis needs to look at effects across all the full life-cycle of the tree, whether natural or artificial. This seems to involve the following steps.

Under what conditions is the tree manufactured or cultivated, with what use of energy, fertilizer, and logging methods? By what combination of transportation mechanisms is the finished tree moved to the home? A substantial share of artificial trees are manufactured in China and then shipped to North America. What are the different issues in use of the tree, including use of water and emissions of fumes? What is the end-of-life for the tree? For example, the carbon in a natural tree will be stored for some decades if the tree goes into a landfill, but not if if is composted or incinerated.

3) The full analysis also needs to look at a range of possible effects. For example, the PE America study looked at "global warming potential (carbon footprint), primary energy demand, acidification potential, eutrophication potential, and smog potential." Here's a figure showing 14 categories of analysis from the ellipsos study, with a comparison between natural and artificial trees on a number of dimensions.

The ellipsos study sums up this way: "When aggregating the data in damage categories, the results show that the impacts for human health are approximately equivalent for both trees, that the impact for ecosystem quality are much better for the artificial tree, that the impacts for climate change are much better for the natural tree, and that the impacts for resources are better for the natural tree ..."

4) In the context of many other holiday and everyday activities, the environmental effects of the tree are small. The studies offer some comparisons of the environmental effects of the tree compared with the electricity used to light the tree, the driving by a household to pick up the tree, and even the environmental effect of the tree stand.

For example, in comparing Primary Energy Demand for the tree and the energy demand for lighting the tree. For an artificial tree, the PE Americas study reports: "The electricity consumption during use of 400 incandescent Christmas tree lights during one Christmas season is 55% of the overall Primary Energy Demand impact of the unlit artificial tree studied, assuming the worst‐case scenario that the artificial tree is used only one year. For artificial trees kept 5 and 10 years respectively, the PED for using incandescent lights is 2.8 times and 5.5 times that of the artificial tree life cycle." For a natural tree: "The life cycle Primary Energy Demand impact of the natural tree is 1.5 ‐ 3.5 times less (based on the End‐of‐Life scenario) than the use of 400 incandescent Christmas tree lights during one Christmas season."

In comparing the environmental effects of driving with those of the tree, ellipsos writes: "Due to the uncertainties of CO2 sequestration and distance between the point of purchase of the trees and the customer’s house, the environmental impacts of the natural tree can become worse. For instance, customers who travel over 16 km from their house to the store (instead of 5 km) to buy a natural tree would be better off with an artificial tree. ... [C]arpooling or biking to work only one to three weeks per year would offset the carbon emissions from both types of Christmas trees."

The PE Americas report strikes a similar theme: "Initially, global warming potential (GWP) for the landfilled natural tree is negative, in other words the life cycle of a landfilled natural tree that is a GWP sink. Therefore, the more natural trees purchased, the greater the environmental global warming benefit (the more negative GWP becomes). However, with increased transport to pick up the natural tree, the overall landfilled natural tree life cycled becomes less negative. When car transport becomes greater than 5 miles (one‐way), the overall life cycle of the natural tree is no longer negative, and there is a positive GWP contribution."

Even the tree stand for a natural tree has an environmental cost that can be considered in the same breath with the costs of a natural tree. PE Americas: "The tree stand is a significant contributor to the overall impact of the natural tree life cycle with impacts ranging from 3% to 41% depending on the impact category and End‐of‐Life disposal option."

I would add that the environment effect of the ornaments on the trees may be as large or greater than the effect of the tree itself. Data from the U.S. Census Bureau shows that America imported $1 billion in Christmas tree ornaments from China (the leading supplier) between January to September 2012, but only $140 million worth of artificial Christmas trees. Thus, spending on ornaments is something like six times as high as spending on trees. The choice of what kind of lights on the tree, or whether to drape the house and front yard with lights, is a more momentous environmental decision than the tree itself.

Of course, these kinds of comparisons don't even try to compare the environmental cost of the tree with the cost of the presents under the tree, or the long-distance travel to attend a family gathering. Thus, the PE Americas study concludes: "Consumers who wish to celebrate the holidays with a Christmas tree should do so knowing that the overall environmental impacts of both natural and artificial trees are extremely small when compared to other daily activities such as driving a car. Neither natural nor artificial Christmas tree purchases constitute a significant environmental impact within most American lifestyles." Similarly, ellipsos writes: "Although the dilemma between the natural and artificial Christmas trees will continue to surface every year before Christmas, it is now clear from this LCA study that, regardless of the chosen type of tree, the impacts on the environment are negligible compared to other activities, such as car use."

Certainly, celebrations at holidays and big events can sometimes be exorbitant and over the top. But the use of a Christmas tree, and the choice between a natural tree or an artificial tree, is a small-scale luxury. If the environmental issue is bothering you, even knowing these facts, make a resolution to use your artificial tree for a few more years, rather than replacing it, or to save some energy in January by driving less or being more vigilant about turning off unneeded lights. Gathering around the tree should be one less reason for moralizing around the holidays, not one more. So celebrate with good cheer and generous moderation.

Thursday, December 18, 2014

In the old days of macroeconomics, say up to 2007, macroeconomic policy was almost entirely about fiscal and monetary policies. But in the last few years, an alternative called "macroprudential policy" has risen up. The notion is to affect the macroeconomy by using financial regulations about the permissable extent of bank capital and collateral lrequirements, consumer borrowing, margin requirements for financial trades, rules governing what derivatives are allowable, and more. Janet Yellen has argued that when it comes to financial stability, and the risks it poses to macroeconomic stability, macroprudential policy needs to play a primary role. Here's a discussion of the past use of what we would now call macroprudential tools in the U.S. economy.

For a useful starting point to the topic, Dirk Schoenmaker has edited an e-book called Macroprudentialism, a VoxEU.org eBook from the Duisenberg School of Finance and the Center for Economic Policy Press, which includes 15 short chapters from various perspectives. Here is a scattering of some of the comments about macroprudential regulation that especially struck me.

Anil K Kashyap, Dimitrios P Tsomocos and Alexandros P. Vardoulakis: "While virtually every central banker in the world is on record supporting the concept of ‘macroprudential regulation’, there is still no agreed upon definition of what it means or how best it should be implemented.

Paul Tucker: "Legislators have typically favoured rules-based regulation. That is for good reason: it
helps to guard against the exercise of arbitrary power by unelected officials. But a static rulebook is the meat and drink of regulatory arbitrage, which is endemic in finance. Finance is a ‘shape-shifter’.
That makes it hard to frame a regime that keeps risk-taking in the system as a whole within tolerable bounds. Instead, excessive risk-taking is likely to migrate to less regulated or unregulated parts of the system. Thus, with the re-regulation of de jure banks currently underway, some of the economic substance of banking will, again, inevitably re-emerge elsewhere. For example, anybody holding low-risk securities can, in principle, build themselves a shadow bank by lending out their securities for cash and investing the proceeds in a riskier credit portfolio. ...

"This shape-shifting dynamic can leave policymakers in a game of catch-up, responding only as each metamorphosis becomes systemically significant. Unless they are empowered to respond flexibly, it is a game they are doomed to lose. By the time the products of regulatory arbitrage are evidently systemically significant, those in the driving street will likely have the lobbying power to delay or derail reform. The powerful forces mobilised to oppose reform of the globally significant US money market fund industry illustrate that in capital letters.

"A number of implications for the design of macroprudential regimes flow from these features of the financial world. First, it will not be sufficient for bank regulation to be dynamically adjusted. It will also be necessary, for example, to vary minimum collateral (margin, haircut) requirements in derivatives and money markets when a cyclical upswing is morphing into exuberance; to tighten the regime applying to a corner of finance that is shifting from systemic irrelevance to a systemic threat; and to tighten the substantive standards, not only the disclosure standards, applying to the issuance
of securities when the pattern of aggregate issuance is driving or facilitating excessive borrowing by firms or households. That means, second, that if finance remains free to innovate, adapt and reshape itself, every kind of financial regulator must be in the business of preserving stability. That needs to be incorporated into their statutory mandates and, more generally, into the design of regulatory agencies."

Charles A. E. Goodhart: "As the Global Financial Crisis struck, central banks were saddled with two objectives at the same time: price stability and financial stability. With the policy interest rate
predicated to achieve price stability, we needed a second instrument to maintain financial stability; hence macroprudential instruments. ... As long as macroprudential instruments are able to vary the capital ratio applicable to loans, they could be effective, but only time will show how effective. ... I have argued that central banks have now been allocated responsibility for financial stability, whether keen to do so or not. If so, it would seem odd not to also give them command over the main levers (i.e. instruments) for achieving such stability. Moreover, several of these instruments involve either imposing requirements on banks – e.g. state-varying capital requirements – or changes to the central bank’s own portfolio – e.g. acting as market-maker of last resort via credit expansion (CE) – that would seem necessarily to be within the natural province of central bank decision-making."

Claudio Borio: "There is no doubt that macroprudential frameworks must be part of the solution to the perennial quest for the so far elusive goal of lasting financial stability. Adopting a more systemic orientation in prudential arrangements is essential. But intellectual pendulums have a habit of swinging too far. There is a risk of entertaining unrealistic expectations about what macroprudential schemes can do on their own. If these expectations become entrenched in policy, there is even an outside risk that, far from being part of the solution, macroprudential frameworks could paradoxically
become part of the problem. Complacency is always not too far around the corner. If the quest for financial stability has proved so elusive, it must be for a reason. Put differently, macroprudential policy must be part of the answer but it cannot be the whole answer. Other policies also need to play their part, not least monetary and fiscal policy. And making the most of macroprudential frameworks calls for a mix of ambition and humility – ambition to make systematic use of the available tools;
humility in recognising their limitations.

Wolf Wagner: The typical regulatory cycle looks as follows. An unwanted behaviour in the financial
system is observed and is attributed to a market failure. Policymakers devise a policy that specifically targets this failure. Upon implementation, it is then discovered that the policy does not work. This is because financial institutions circumvent the spirit of the policy by shifting into economically equivalent activities that are not affected by regulation. In addition, the responses of market participants often lead to undesirable outcomes in other parts of the financial system. The apparent failure of regulation in turn leads to a series of new, and increasingly complex, measures, which by themselves bring about further unintended consequences. ...

Naively designed macroprudential policies are likely to have unintended effects. Due to the inherently complex nature of systemic policies, the scope for such side effects is much larger than for traditional policies, and may easily come to outweigh the benefits. Policymakers need to step up their efforts in making sure that new macroprudential policies are incentive-compatible and do not distort the behaviour of participants in the financial system.